Economic Outlook and 2008 Global Economic Forecast

End of the Year (2007) Economic Outlook and 2008 Global Economic Forecast

Published December 29, 2007

This position paper overviews the current stage of the US and Global economy and analyzes the prospective development of economic trends. Evidently, the currently overvalued Housing Market is experiencing a major price adjustment. For years, greedy financial institutions were selling “cheap” mortgages, thus pushing the housing prices up to high-sky levels. We are witnessing the first wave of foreclosures and bankruptcies sweeping across America. In response, the Financial Markets are revaluating overpriced stocks. Wall Streets’ optimists claim that everything will be fine by next year; the government has been adding more liquidity to markets, despite growing inflation, but the reality is: the economic growth cycle is over and we are now entering into recession.

Let’s see what’s in the news now:

During the week ending on December 14^th, mortgage application volume dropped by 19.5%, purchase volume dropped by 10.6%, and refinance volume 27.3%.
CNN Money Online – Dec 19 (1)

The purchase index rose 6.1%... Building permits fell to their lowest level in 16 years… Los Angeles and Orange Counties outpaced declines in other major metro areas in September as home prices fell at a record pace. Prices fell 7% as opposed to an average of 4.9% in 20 metro areas nationwide. The 2nd quarter had fallen 3.2%, which had been the sharpest fall since the index began in 1987. San Diego recorded the third worst decline, with a 9.6% drop from the previous year and in Florida, Tampa fell 11.1% and Miami 10%. A US Conference of Mayors predicted another 16% decline for California home prices in 2008 and a nationwide decline of 7%. The Conference of Mayor’s report assumes 1.4 million homeowners will face foreclosure in 2008, walking away from $316 billion in houses…

Bob Chapman – Dec 3 (2)

The Chung-Hua Institution for Economic Research (CHIER) yesterday revised its projection for Taiwan's economic growth to 4.16 percent for 2008 from 4.41 percent, due to some uncertain factors, such as what they characterized as a "domestically cold, externally warm" economic condition…
Chinapost.com.tw – Dec 5 (3)

Europe's economic growth is slowing more than forecast by the European Union and may drop below 2 percent in 2008 for the first time in three years, EU Monetary Affairs Commissioner Joaquin Almunia said…s
Bloomberg.com – Dec 6 (4)

(Georgia) at 40% Risk of Recession. The housing slump, rising energy costs and drought will have Georgia's economy at the edge of a recession for the first half of 2008, according to a forecast released Tuesday by The University of Georgia's Selig Center for Economic Growth…

Atlanta Business Chronicle - Dec 04 (5)

Chinese leaders hold economic work meet. China's leaders met Monday in Beijing to thrash out economic policy for 2008, seeking to cool inflation and excess investment without stifling the growth needed to keep incomes and employment rising…
Denver Post - Dec 03 (6)

The consumer price index increased 0.8 percent in November, up from 0.3 percent the previous month, the Labor Department said today in Washington. Prices excluding food and energy climbed 0.3 percent, also more than economists anticipated…
Bloomberg - Dec 14 (7)

In a special report, the ITEM Club looks at the effects of the credit crunch on a number of the world's economies, and concludes that a consumer slowdown is likely in the UK as real incomes stagnate and interest costs rise. There is also a real risk that the growth in the UK's financial services industry - which last year contributed 0.8% to UK GDP growth - could be cut right back over the coming year. Furthermore, employment reductions and loss of bonus payments in this sector could knock the stuffing out of the UK housing market…t
Ernst & Young - Dec 14 (8)

U.S. stocks tumbled the most in a month as investors speculated the Federal Reserve's quarter-point interest-rate cut will fail to prevent a recession... Some investors had expected the Fed to do more to preserve the economy's six-year expansion…
Bloomberg - Dec 11 (9)

Odds (that) the Federal Reserve will cut interest rates by half a point next week surpassed 50 percent for the first time, according to trading in futures contracts, reflecting concern banks face more losses on securities tied to subprime loans…
Bloomberg – Dec 4 (10)

How hard is the credit crunch hitting the economy?

The credit crisis we are currently witnessing has extended to subprime and ALT-A loans, banks and Wall Street. The credit crisis began with an overpriced US housing market and is now spreading worldwide. Residential real estate demand remains quite depressed with only a few tentative and scattered signs of stabilization, amidst the ongoing slump.

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All of the economic and financial news seems increasingly negative. In an attempt to pull the economy out of recession, our government has been manipulating the stock market. The Treasury Secretary Paulson wants Congress to allow the FHA to buy mortgages in greater volume, despite the FHA’s existing debt to lenders that is already in the hundreds of billions of dollars. In California, the Governor is dealing with thousands of home owners who are currently faced with Foreclosure. Paulson predicts even worse problems in the mortgage market next year. (12)

The Fed Chairman Ben S. Bernanke has cut rates for the fourth FOMC meeting in a row: he is giving more liquidity to markets, extending the agony, in an attempt to stabilize the markets through the holidays. His efforts are evidently not enough, because even after the Fed cut rates, the stock market still lost 300 points. Market participants fear that the current rate cuts are not aggressive enough to prevent the stock market from falling, but the Fed may have less room to lower borrowing costs than investors in the Treasury anticipated, potentially setting bondholders up for a fall. (13)

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The Fed is performing a difficult balancing act between inflation risk and Market price depreciation. “The Fed is willing to tolerate short-run movements in inflation, but only as long as those movements don't appear to be dislodging long-run inflation expectations. Any evidence that accelerating inflation is becoming entrenched may heighten the Fed's debate as policy makers consider cutting rates to keep the worst housing market in 16 years and mounting losses in securities related to subprime mortgages from tipping the economy into recession.”
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Debt Service Payments and most economic indicators suggest that a rise in rates in the near future is unavoidable. And as liquidity decreases, our financial system will fall into an even deeper crisis.

With the U.S. trade deficit so high, there is hope that dollar depreciation will curb the U.S. appetite for foreign goods by pushing up the cost of imports. Yet three factors—the use of the dollar in invoicing U.S. trade, the market share concerns of exporters, and sizable U.S. distribution costs—could keep U.S. import prices from rising enough to reduce demand significantly. Evidence suggests that a weaker dollar will boost foreign demand for U.S. exports, but this adjustment alone is unlikely to close the deficit. (17)

Dollar depreciation in the upcoming year is not a guarantee; several factors are currently positively affecting the value of U.S. currency: improving U.S. trade, damage from a weak U.S. economy spreading to other countries, the prospect of lower interest rates in Europe and overwhelming disenchantment with the dollar's decline. Unfortunately, a boost in the value of U.S. currency can have a major negative consequence: the volume of US exports will decrease, and the trade deficit may go even higher. (18)

Do we have a chance to avoid the Recession?

Probably not...

Let’s look at some other Forecasting instruments:

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“The yield curve—specifically, the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill—is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.” (20) As you can see this probability curve rises right before each recession (highlighted gray period on the chart) and right now it is up to 0.4 or 40%. Considering the fact that last two recessions were short-lived, it is likely that this one may affect the economy for a longer period of time or will lead to a series of recessions, as was the case in the early nineteen eighties. “Before each of the last six recessions, short-term interest rates rose above long-term rates, reversing the customary pattern and producing what economists call a yield curve inversion. Thus, it is not surprising that the recent flattening of the yield curve has attracted the attention of the media and financial markets and prompted speculation about the possibility of a new downturn.” (21)

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The “yield curve inversion” is a bottom-forming pattern located that originates below the zero line, which typically precedes a recession period (gray on the chart). It is revealed on the chart above that we are witnessing this particular pattern right now.

Another leading indicator of a recession is the Unemployment Rate. According to analytical studies, the unemployment rate reaches its lowest readings in the cycle right before a recession; the rate reverses and stats sharply rise during the recession. The Fed’s policy makers always consider employment figures when making decisions on interest rates.

The chart below shows that the unemployment rate is staring to go up.

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Another major indicator is Fixed Investment. Fixed Investments rates tend to fall below zero right before a recession.

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The above charts reveal that these rates have been below zero since 2007, indicating the current housing market; we are already in a recession.

Why are we only now seeing signs of this recession, if the downturn in the market was logically predetermined by economic cycles? Price stickiness—the tendency of prices to remain constant despite changes in supply and demand. The unwillingness of real estate developers and homeowners to reevaluate properties prices was a major cause of price stickiness. The “housing bubble” and financial lending crisis cannot be easily solved – someone has to take a loss; creative lenders and borrowers are shifting hidden losses from one account to another, but sooner or later, the “bubble” will pop and prices will inevitably fall. Prices will settle at a fair value, and new buyers can purchase these previously overvalued properties. The market has only now just started falling, so it will be some time before the market hits bottom.

The Equity Market will succumb to the same pattern, but faster and with less price volatility.

What about the rest of the World’s Economies?

There is economic concern throughout Asia as well as in Europe. In some countries, yields on 3-month deposits have fallen to 1%, which is a serious warning sign. China's industrial production slowed drastically this year, suggesting weaker export growth and leading to the Chinese government curbing its lending; the world's fastest-growing major economy is starting to slow. In Europe, Interbank Covered Bond Trading, which has a trillion euros of covered bonds outstanding, has been suspended since the end of November. (25)

No surprise here, as the saying goes: When the U.S. sneezes, the rest of the World catches cold…

The Federal Reserve, European Central Bank and three other central banks moved in concert in an attempt to relieve a credit squeeze that was threatening global growth, in the biggest act of international economic cooperation since the Sept. 11 terrorist attacks. (26) But it is not only the housing slump that is pushing the economy into a recession. “Over the past few years, there has been growing concern that the U.S. capital markets are losing market share to overseas competitors. Indeed, many observers have singled out the decline in the number of foreign initial public offerings (IPOs) on the New York Stock Exchange and the NASDAQ as evidence of the U.S. equity markets’ waning appeal. Yet the collapse of the dot-com industry in 2000 or overvalued housing market right now did not impact the U.S. markets alone—it also caused a significant slowdown in business activity in overseas venues such as Euronext, Deutsche Börse, and the Hong Kong Stock Exchange.” (27)

Conclusion.

Recession is here and it is unavoidable. It could take more then a year to recover from this recession and there is always the possibility of a series of recessions, as was the case in the beginning of the 1980’s. We must admit that our net worth is equal to the amount of money that we have in our pocket and not the value documented on our mortgages. We have to accept our losses, and let the market reevaluate itself.

Where to invest in 2008?

Even though a decline in the stock market is expected, especially in the first half of 2008, U.S. stock exchanges and American stocks are still the most liquid and the most actively traded instruments in the World. And some short-term investment tactics could work in this volatile sideways market. The U.S. Dollar will likely rebound. Bond and government securities market look promising, considering the expected rate hikes by the end of 2008. Gold and silver are considered attractive investments during periods of recession. Generally, commodities markets are good investments. Worldwide, the main prediction is that, among industrialized countries, capital should be expected to flow towards relatively young and rapidly growing economies, where rates of returns are more comparable to the investment risks during this period of global economic recession.

Andrey Korchnoy, CTA

Sources and References

(1) CNN Money. “Mortgage applications tumble, MBA says.” December 19, 2007. http://money.cnn.com/2007/12/19/real_estate/mortgage_applications.ap/index.htm?postversion=2007121907 viewed on December 21, 2007.

(2) Chapman, Bob. Investor Village. “US Markets.” December 3, 2007.

http://www.investorvillage.com/smbd.asp?mb=4165&mn=6844&pt=msg&mid=3582799 viewed on December 21, 2007.

(3) The China Post. “Chier Iowers Taiwan’s economic growth forecast to 4.16% for 2008.” December 5, 2007. http://www.chinapost.com.tw/headlines/2007/12/05/50794/CHIER-lowers.htm viewed on December 21, 2007

(4) Meier, Simone. Bloomberg. “ECB Keeps Rate at 4% as Inflation Jumps, Growth Slows.” December 6, 2007. http://www.bloomberg.com/apps/news?pid=20601100&sid=a.XisuXWFoKc&refer=germany viewed on December 21, 2007.

(5) Atlanta Business Chronicle. “UGA forecast: State at 40% risk of recession in 2008.” December 4, 2007. http://atlanta.bizjournals.com/atlanta/stories/2007/12/03/daily14.html?surround=lfn viewed on December 21, 2007.

(6) Kurtenbach, Elaine. Denver Post. “Chinese leaders hold economic work meet.” December 3, 2007. http://www.denverpost.com/business/ci_7623033 viewed on December 21, 2007.

(7) Chandra, Shobhana. Bloomberg. “U.S. Economy: Consumer Prices Rise More Than Forecast.” December 14, 2007 http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=aK90K4wLy_F4 viewed on December 21, 2007

(8) Ernst & Young. “Ernst & Young Item Club.” http://www.ey.com/global/Content.nsf/UK/Economic_Outlook viewed on December 21, 2007.

(9) Martin, Eric. Bloomberg. “U.S. Stocks Fall After Fed Cuts Benchmark Rate by Quarter Point.” December 11, 2007. http://www.bloomberg.com/apps/news?pid=20601087&sid=al5MUt_Et9lk&refer=home viewed on December 21, 2007.

(10) Lynn Thomasson and Eric Martin. Bloomberg. “Traders See 50% Odds Fed Will Cut Rate by Half Point.” December 4, 2007. http://www.bloomberg.com/apps/news?pid=20601087&sid=aacKziLAmZec&refer=home viewed on December 21, 2007.

(11) Charts: “Housing Starts and Single Family Home Sales.” Census Bureau, US Dept. of Commerce. 2007.

(12) Chapman, Bob. Investor Village. “US Markets.” December 3, 2007.

http://www.investorvillage.com/smbd.asp?mb=4165&mn=6844&pt=msg&mid=3582799 viewed on December 21, 2007.

(13) Liz Capo McCormick and Sandra Hernandez. Bloomberg. “Price Measure Says Rate Can't Fall as Traders Expect/” December 10, 2007. http://www.bloomberg.com/apps/news?pid=20601087&sid=a_fz9yFswePE&refer=home viewed on December 21, 2007.

(14) Chart: “Short Term Interest Rates.” Census Bureau, US Dept. of Commerce. 2007.

(15) Liz Capo McCormick and Sandra Hernandez. Bloomberg. “Price Measure Says Rate Can't Fall as Traders Expect/” December 10, 2007. http://www.bloomberg.com/apps/news?pid=20601087&sid=a_fz9yFswePE&refer=home viewed on December 21, 2007.

(16) Chart: “Debt service payments and Household debt outstanding.” United States Department of Treasury and Federal Reserve Board, Index of industrial production, treasury yields, exchange rates, capacity utilization, household debt. December 2007

(17) The International Forecaster. “Trade Imbalances.” July 15, 2007. http://theinternationalforecaster.com/item.php?articleid=185 viewed on December 21, 2007.

(18) Sesit, Michael. Interntaional Herald Tribune. “Viewpoint: The dollar's redemption.” December 9, 2007. http://www.iht.com/articles/2007/12/09/bloomberg/sxview.php viewed on December 21, 2007.

(19) Chart: “Probability of US Recession Predicted by Treasury Spread.” United States Department of Treasury and Federal Reserve Board. 2007.

(20) Arturo Estrella and Frederic S. Mishkin. Current Issues in Economics and Finance. “The Yield Curve as a Predictor of US Recessions.” Volume 2 Number 7. June 1996.

(21) Arturo Estrella and Mary Trubin. Current Issues in Economics and Finance. “The Yield Curve as a Leading Indicator: Some Practical Issues.” Volume 12 Number 5. July/August 2006.

(22) Chart: “Treasury Spread: 10 yr bond rate-3 month bill rate.” United States Department of Treasury and Federal Reserve Board. 2007.

(23) Chart: “Civilian Unemployment Rate.” Census Bureau, US Dept. of Commerce. 2007.

(24) Chart: “Private Fixed Investment” and “Real Residential Fixed Investment.” Census Bureau, US Dept. of Commerce. 2007.

(25) Chapman, Bob. Investor Village. “US Markets.” December 3, 2007.
http://www.investorvillage.com/smbd.asp?mb=4165&mn=6844&pt=msg&mid=3582799 viewed on December 21, 2007.

(26) Lanman, Scott. Bloomberg. “Fed, ECB, Central Banks Work to Ease Credit Crunch.” December 12, 2007. http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a8Oed.hCgAvo viewed on December 21, 2007.

(27) Editors: Elliott, C.W.J. Granger, and A. Peristiani. Handbook of Economic Forecasting. “Leading Indicators in Capital Markets.” Amsterdam: Elsevier. 2006.